Thursday, January 31, 2013

In my last post, I looked at the options that investors in Apple face today. In this one, I hope to look at what Apple can learn from the market mayhem in its stock, and, in the process, adapt. As an Apple stockholder now, I am at least partly motivated by self interest, but I am also a long time Apple product user and I would like to see the company on steadier footing. So, here are some general suggestions that I would have for Apple management (though I am sure that they are much too busy tending to day-to-day business to be reading blog posts):

Build up credibility with investors: The company has to regain credibility with investors. Apple has acquired a reputation for lowballing its expected results, prior to earnings reports. Instead of making it easier for the company to beat expectations, it has led instead to markets paying little heed to the guidance. In fact, it looks like Apple is taking the first step towards doing this by adopting the Amazon strategy of giving wide bands of forecasts for expected earnings. There will be traders/analysts/investors who will be upset, and may abandon the stock. Good!!!

Be transparent: Become more open about long-term strategy and products. I think that Apple’s secrecy about new products and strategies may be a great marketing strategy but it creates an information vacuum, which is filled with rumors and fantasy. I know that Apple also worries about giving away information to its competitors, but when you are a company the size of Apple, the news will get out to your competitors any way. So, stop acting like you are protecting national security and start acting like a business!!

Take a stand: The company has to stop trying to be all things to all investors and make its stand on whether it sees itself more as a growth company or a more mature company. Picking one does not mean that the company is giving up on the other, since a mature company can still pursues growth prospects, but it does lay down markers that will determine your investor base.

Behave consistently with your choice: Once Apple makes its stand as a growth or mature company, it has to behave consistently. Thus, if it decides that it is a mature company, it should return more cash to its stockholders, though I think stock buybacks make more sense to its stockholder base now than dividends do. At the moment, with its huge cash balance, it clearly does not make any sense for Apple to borrow money, but somewhere down the road, it has to consider the debt option, since not using it is depriving itself of the tax benefits embedded in the tax code for using debt instead of equity.

I know... I know... All of this will make Apple a more boring company, but I do have one avenue that the company should explore that can still provide excitement to investors, while also creating value. Apple’s great successes in the last decade have come from “creative destruction”, where it has gone into established markets with game changers – retailing with iTunes and Apple stores, portable music players with the iPod, the cell phone market with the iPhone and the tablet market with the iPad. Its success in each of these markets has made it a large player in each of them, which is a problem. As Clayton Christensen, Harvard’s strategy guru, notes, it is difficult for established players to be "disruptive innovators" because they have too much to lose, and Apple can no longer afford to be revolutionary in any of its existing markets. It has two choices. It can put its youthful, creative destruction ways behind in and grow up, or it can go for creative destruction in new markets. I think it should try for a combination, playing defense in the smartphone and tablet markets, and using its competitive advantages to crack open new markets. Unlike Samsung or Microsoft, Apple has never been just a technology company. Its strength has always come from a unique mix of design (software & hardware), elegance and efficiency, and it is this combination that has given it pricing power.

So, where should Apple look next? I would suggest looking for businesses where existing companies churn out poorly designed and consumer-unfriendly products, but are trapped by a lack of imagination and legacy choices into continuing down that path. I can think of at least a dozen that I use or interact with on a day-to-day basis. While televisions have been bandied about as the next big Apple market, I don’t see why the business has to be electronic. I am sure that my airline experience would be better on Apple Air, my hotel stay more comfortable at Apple Hotels and my tax money better spent with Apple Government.

Sunday, January 27, 2013

The bottom has clearly fallen out for Apple's stock price. After last week's earnings report, the stock that had already dropped 30% from its high of $705 set in September to $500/share, dropped another 15% to finish at $440/share. The company that could do no wrong a few months ago now is viewed as incapable of doing anything right. Has the stock fallen too much or is this just the beginning of a longer term drop in value? Is it time to buy, time to sell or time to sit on your hands?

Looking at the landscape, I would categorize Apple investors and potential investors into three groups right now, based on their views of its value and the current price.

The Pricers: As I see it, the bulk of the investors in Apple have no idea what the value of the stock is and do not care that they don't know its value. They are intent on playing the pricing game, where the key becomes gauging what the rest of the crowd thinks about the stock and trying to get ahead of them. At any stock price, the question they ask is not whether Apple is under or over valued, but whether the price will go up or down in the near term. I have never been good at this game and it must be exhausting, being at the mercy of market sentiment, moods and fancy.

The Value Skeptics: This group has always viewed Apple's rapid rise to the top of the market cap heap with suspicion, convinced that its value could not have risen that fast. Some of this group belong to the hardcore value camp, where no technology company, especially one with intangible assets and an elusive "cool" factor, would be a good value, at any price. Some, though, have reasonable doubts about the capacity of technology companies to maintain earnings in an volatile environment and believe that those of us who assume long term growth prospects for these companies are under estimating the risk of the disruption from new technologies. Just as Apple undercut RIMM and Nokia, they believe that some other company will undercut Apple in the future. Many in this group are feeling self-righteous, arguing the price drop was long overdue but not enough to make the company an attractive investment yet.

The Value Optimists: This group believes that Apple is a bargain at $440 and that its true value is much higher. Some, in this group, base this judgment on simple comparisons. At a market cap of $413 billion, with a cash balance of $120 billion and net income of $42 billion, they note that Apple is trading at roughly seven times earnings, cheap in a market where the median PE ratio is about 16. Some are basing their views on cash flow based valuations and I am one of that group, as you probably already know from my post at the end of 2012. In that post, I valued Apple at $609/share and the latest earnings report barely changes that estimate. I did a follow up simulation, bringing in the uncertainty about my estimates about revenue growth(-2% to +14%), margins (25% to 35%) and cost of capital (11%-14%) into the mix, with the following outcomes:

Based on my estimates, and they could be skewed by my Apple bias, at its current stock price of $440, there is a 90% chance that the stock is under valued.

If, like me, you are in this last group, you are being tested mightily now, torn between a belief that the stock is under valued and a market that does not seem to care. It is a good test of whether you are a value investor and what you do will depend upon two assessments:

The Gut Check: Are you really a value investor or do you just like talking like one? It is easy being a contrarian value investor, in the abstract, but much more difficult to be one in practice, since you are taking a position at odds with the rest of the market. Not all investors have the stomach for that, and if you don't, it is a good time to find out.

The Confidence Check: How confident are you in your assessment of value? That confidence will stem from your comfort with the valuation metric/model that you used and the inputs that you used in that model, as well as from your prior experience in investing based on your valuations. Again, you cannot talk yourself into being confident, and if you are not, it is best not to take a stand.

If you pass the value investing test and feel confident in your assessment of value, I think you should take the leap. If you do, as I did (albeit at $500/share), keep the following cautionary notes in mind:

Don't bet the house: No matter how confident you are in your value assessment, don't go overboard and invest a disproportionate amount of your portfolio in Apple. This is not just about you being right on the value but also about the market coming around to your point of view, and that is not in your control or mine; betting more than 10% of your portfolio on this stock strikes me as foolhardy.

Don't double down (Dollar averaging): I have never been a fan of dollar averaging, which not only muddies the water about when/how much you invested in a stock but results in increasing your bets as the market goes against you. Take a stand against the market but do not make this an ego trip, where admitting that you are wrong becomes impossible to do. Thus, while I feel more confident now that the stock is under valued than I was a week ago when I bought the stock for $500, I don't plan to buy more shares.

Think of buying the business, not the stock: The old adage that you are buying a piece of a company, not a share of stock, is particularly relevant when you make a bet like this one. My intrinsic valuation is determined by Apple's capacity to generate profits and cash flows and is not dependent upon whether portfolio managers are investing with me or analysts are lowering their price estimates. If I buy Apple at $440 today and I can hold the stock, I will get a share of a cash that is paid out and a share of ownership in the cash that is withheld. I have to keep reminding myself of that truth, even if the market moves against me.

Do not track the day to day stories: In an increasingly connected world, I know that this is really difficult to do, but there is no harm trying. Turn off your financial news channel, don't read opinion stories about Apple and avoid equity research reports like the plague.

Be willing to wait... even if you are not sure what you are waiting for: The big question that those of us who chose to make this bet face is what the catalyst will be that brings the market back to its senses (at least as we see it...). From my experience, it is almost impossible to tell. For instance, how did Netflix, which was a tailspin, a year ago, turn itself around? There was no single precipitating event but a collection of small news stories and solid earnings reports that seemed to settle the fears that investors had about the company's future direction. With Apple, it could be a new product, a couple of healthy earnings reports or a stock buyback.

Let me close by saying that I will go to bed tonight, not thinking about what Apple's stock price will do tomorrow or the day after. I have made my choice and I am at peace with it. If you lie awake at night thinking about the stocks you have bought or sold, you just failed the final test of value investing.

Sunday, January 13, 2013

For the last two decades, I have dedicated the first two weeks of each new year to a ritual. I obtain/collect/download data on all publicly traded companies listed globally, using a variety of data sources, and then analyze and present the data, aggregated at a number of different levels: by country, by region (US, Europe, Emerging Markets, Japan, Australia & Canada) and by industry. I report on measures of operations (profit margins, turnover ratios, working capital), measures of leverage (debt ratios), measures of risk (beta, standard deviation, equity risk premiums, country risk premiums) and pricing measures (earnings multiples, book value multiples, revenue multiples). I just completed my 2013 update and you can find it by clicking here.

I start with a belief that all data should be accessible and available to all investors at low or no cost, but my motives for providing my reading of the data are far from altruistic. I draw on the numbers that I estimate through the rest of the year for my teaching, analysis (valuation or corporate finance) and writing (blogs, books). In other words, I would have analyzed all of this data anyway and having completed the work, I see little benefit in keeping it behind a pay wall or passwords. Let me hasten to add that nothing that I do is particularly original nor is it path breaking and my task is made easier by the easy access that we have to raw data. I do hope, though, that while I do make mistakes, that I have not let my personal biases or views color the data, and that that nothing that I do is opaque.

Each year, I also try to add something new to the dataset to keep it fresh and this year, I have added company-specific estimates of costs of equity and capital (in US dollar terms) in the individual company data sets (look to the top of the linked data page). In making these estimates, though, I had to make very broad assumptions about country risk. For instance, I used the risk premium of the country of incorporation to the company, though it is preferable to use the risk premium based on operations. So, take these cost of capital estimates with a grain of salt, and if you prefer a more precise estimate for a company, you should do in more detail.

When I finished my update a year ago, I posted on it here, and talked about one of my favorite movies/books, Moneyball, in the context of arguing that intuition & experience were vastly overrated in business. Much of what we think we have learned or think we know about investing and corporate finance is skewed by psychological flaws that we all share: faulty framing, hindsight bias and selective memory, and good data can play a cleansing role. That post represented the “good” that I see in data/numbers, and I thought that this year’s post, for balance, should offer the other side of the argument. I know that data can be misused and manipulated, and that some of my own data has been used to back up specious arguments in multiple settings. In particular, here are three practices relating to data that I find distasteful and suggestions on how you can counter them.

1. Data to intimidate: An article in the Wall Street Journal pointed to fact that people who are unfamiliar with numbers tend to give them too much weight to them and are particularly swayed by "mathematical" arguments, even if they are nonsensical. It is this weakness that is used by some number crunchers to intimidate those that may not have the same degree of facility with numbers. I have seen corporate financial analyses and valuations where analysts use table after table of numbers, to bludgeon others into submission, using acronyms, jargon and greek alphabets to further the rout.The counter: The best weapons against number intimidation are common sense and a focus on the big picture. I hope that having access to my data will give you some ammunition in this endeavor but having a solid grounding in first principles of valuation and corporate finance alway helps.

2. Data to mislead: If you have access to a great deal of data, you can parse the data and choose pieces to back up a preconception or argument that you want to advance. A couple of years ago, the effective tax rates that I publish on my site, for US companies, were used by some to advance the argument that US companies were not paying enough in taxes. Looking at the 2013 update on tax rates, that number is low (14.93%), but it is the average effective tax rate across all US companies, including those that are money losing (and thus paid no taxes). Looking only at money-making companies, the average effective tax rate is 28.37%, and the weighted average tax rate is even higher at 30.05%. So, if you have an agenda, you can take your pick to make the argument that US companies pay too little, just enough or even too much in taxes.The counter: While there is little that you can do to stop people from using data selectively, you can counter their arguments by presenting them with the numbers that they are ignoring. In fact, it was in response to the tax rate debate that I started reporting the average tax rates for money-making companies and aggregated tax rates in my datasets.

3. Data to deflect and evade responsibility: Many analysts use data to avoid making tough judgments about businesses or dealing with uncertainty. Thus, assuming that a company will earn a profit margin typical of the industry is much easier to do than analyzing its competitive advantages and estimating a margin, based on your assessment. Similarly, using a historical or a service supplied equity risk premium in valuation is far simpler than estimating one, based upon the macroeconomic risks that we face in markets today. In fact, using an expert or a service estimate of these numbers (using an equity risk premium from a data service like Ibbotson or even my website) allows analysts to claim immunity from errors and to pass the buck, if the numbers turn out to be wrong in hindsight.The counter: I have absolutely no concerns about you borrowing data and spreadsheets from my website but please make them your own by adapting and modifying them to not only fit your needs to but also to reflect your points of view.

I hope that you find my data useful in your work or research. If you do, that is more than sufficient return on any time that I have invested in putting it together. If you can think of ways in which it can be more useful or complete, please do let me know and I will try my best to incorporate those suggestions into next year's update.